Senior loan funds, hobbled by heavy net redemptions and relegated to the sidelines over the last 18 months, may be primed for a more active role in the loan investment markets. A more favorable environment is seen to be taking shape and should translate into more participation by the floating rate funds, market players said.
Prime rate funds now control roughly 20% of the institutional bank loan market. In their heyday in the late 1990s, prime rate funds made up about 80% of the institutional market. To be sure, much of the decline in share can be attributed to the huge popularity of collateralized debt obligations. But some comes from a lousy market for floating-rate funds. Low interest rates and a high level of defaults have sparked redemptions. The loan funds have been paying out instead of investing.
But Jon Maier, a director in global equity research at UBS Warburg, said the tide should be turning in the funds' favor. The UBS equity group has initiated coverage on the family of five closed-end senior loan funds Eaton Vance Senior Income Trust, Nuveen Senior Income Fund, Van Kampen Senior Income Trust, ING Prime Rate Trust and Travelers Corporate Loan Fund. All of the funds have been given a rating of "buy" except for Travelers Corporate Loan Fund, which has been given a rating of "hold" because of its lagging NAV this year and relatively small size. Portfolio managers at Nuveen, Eaton Vance, ING, and Travelers could not be reached by press time.
If the trends are in fact reversing, then the loan market is likely to see prime rate funds becoming a more active buyer of loans on both the new issue and secondary market side. "When money comes into these funds, it has to be put to work," said Art Zimmer, senior v.p. and portfolio manager at OppenheimerFunds.
Currently, prime rate funds are trading at a large discount, reflecting both the market interpretation of the risks associated with the funds as well as the average price of their bank loan assets. Howard Tiffen, senior portfolio manager of Van Kampen Senior Income Trust, explained that this discount is almost 30%. "Every fund in this asset class is trading at a discount," Tiffen noted.
Still some are taking a more bearish view when it comes to the economic recovery, and therefore also the investment opportunity of senior loan funds. Recent statistics released by Lipper suggest that outflows from prime funds are still strong, with $785 million in net redemptions for the month of October. "My personal sense is that the economy is still soft," said Don Cassidy, senior research analyst at Lipper. Cassidy explained that for conditions to be conducive to senior loan funds, an investor must assume that the fund's principal will no longer be eroded by a high level of defaults, and that interest rates have bottomed out and will go higher.
Interest rates, of course, are the key. "People forget that these are floating rates, so as interest rates rise, so does your income," said Maier. The only question is when this will happen. Cassidy's advice to investors is to watch the funds' NAVs for a couple of months and if they begin to improve because default rates have settled down then it could be a good time to invest in senior loan funds. Tiffen has a slightly more upbeat view. "It does appear that real interest rates are zero or below, taking into account inflation," he commented. Tiffen believes that monetary policy will eventually swing the economy into gear. "I feel more optimistic than I did three months ago," he said.
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